H&R Block: Still an Appealing Investment Despite an Unhappy Year

H&R Block (NYSE:HRB) was founded by two brothers shortly after the Second World War as a bookkeeping business. In a short time they came to realize that handling tax returns for individuals could be lucrative. H&R Block dominates the current tax preparation market and also owns RSM McLadrey which provides business services to mid size firms.

The shareholders of H&R Block have had an unhappy year as they have watched their investment decline by about 45%, even including reinvested dividends. Such a decline is typically a cause for pause and analysis to determine if the selling has gone too far. This analysis follows, but first consider a brief overview of H&R Block and its industry.

Industry and Business Overview

The IRS provides data on tax filings each year. The latest data can be found here.

Of the 144 million tax filers, 57.7% (or 83 million) chose to pay someone else to prepare the return for the 2010 tax season. H&R Block is the clear leader, with 20.1 million tax filings prepared in the United States (about 14.2 million came from retail operations and 5.9 million from digital sources). The company also owns tax preparation businesses in Canada and Australia.

H&R Block is somewhat unique in having exposure to both retail and digital tax preparation. Intuit is the leader for digital tax preparation having sold about 20 million units of TurboTax last season (here is a link to the press release from Intuit detailing the performance of TurboTax last season). On October 13th H&R Block announced that it had entered into an agreement to purchase 2SS Holdings which produces TaxAct software. Should the deal close it would strengthen the company’s second place position in the digital market.

The largest competitors in the retail market are Jackson-Hewitt and Liberty Tax. Liberty is privately held, but Jackson-Hewitt prepared about 2.5 million tax returns in the United States last year. Tax preparation is clearly a rather segmented market with thousands of independent accountants and firms offering service throughout the country.

RSM McGladrey contributed $867 million in revenue last fiscal year and $59 million in pre-tax profits, about 22% and 7% of H&R Block’s consolidated totals respectively. Since a firm not owned by a CPA is legally prohibited from providing attestation services, a relationship exists with the partnership McGladrey & Pullen LLP so that both attest and non-attest services can be provided. The firm targets mid sized companies and also has a separate division (RSM EquiCo) that provides capital markets expertise.

Reasons for Decline

Three primary reasons exist for H&R Block’s sell off. I would like to both outline these and discuss them in some detail.

Secular Shifts in Tax Filings

The first is a long term shift in the way American’s file tax returns. Previously an individual could file taxes on his own or seek the help of an accountant or specialized firm such as H&R Block. Tax software has introduced a third option which allows filers to file returns in a guided manner that is sufficient for individuals without extremely complex returns. After completing the documents, filing the return electronically is simple. This presents a challenge to H&R Block’s traditional retail business, where its position is strong and revenue per transaction is much higher than for digital transactions.

The retail tax business is in decline, to be sure. But H&R Block being the strongest firm is best positioned for inevitable consolidation. The company has been working to turn independent competitors into H&R Block franchises. This gives owners the opportunity to continue to take an active role in their business while benefiting from H&R Block’s scale. On the most recent earnings call, Alan Bennett, the company’s CEO, stated that this year the company will gain about 140,000 incremental filings from these purchases.

It also appears that the company is seizing opportunity to improve productivity and cut expenses. For the first time, the company is categorizing accountants by their ability to retain clients and direct more business to those performing the best. Controlling expenses has been among the biggest reasons why operating losses have fallen in the most reason two quarters (losses are typical outside of tax season).

One fact often overlooked is that the presence of H&R Block in both the retail and digital segments allows for opportunities that can be further exploited. For example, an individual purchasing digital software can speak to an accountant should questions arise. Digital competitors lack this infrastructure. The acquisition of 2SS has not closed yet, but at the time the acquisition was announced H&R Block said they expected to gain about 5 million unit sales. TaxAct has among the lowest selling price of all software, but combining the two operations will allow for the elimination of certain expenses (not least of which is simply researching the tax code each year). It seems likely that in the future H&R Block At Home and TaxAct will be developed in parallel as well, saving programming expenses. Management stated that if the deal closed in 2010 (it likely will not) it should be accretive to earnings in the amount of $.05 a share. That equates to about $16 million versus a purchase price of $288 million.

Ironically, the most recent sell off in H&R Block’s stock came following an announcement concerning Refund Anticipation Loans (RAL). While earnings will be hurt in the current tax season, the elimination of this financial product may prove to be a long term benefit to the company.

Refund Anticipation Loans

H&R Block announced on December 27th that HSBC was prohibited from participating in the program in the coming tax season at the direction of the Office of the Comptroller of Currency. If you are interested in reading about RAL’s, this link directs you to the National Consumer Loan Center’s 2010 report on these loans.

A company issuing a RAL fronts the anticipated refund to the customer through bank funding, allowing the customer to receive funds one to two weeks early but at a steep price. For the year 2008 the average RAL was $3,300 and cost about $88 in fees. Had H&R Block offered the service the charge would have been $29.95 plus 1.07% of the loan amount. The typical annualized rate of 72% (based upon the $88 average cost for borrowing $3,300 for two weeks) has been seen as predatory by many, not least by some in Washington. As such the decision to bar HSBC from making the loans was not an isolated one. It is part of a trend towards limiting the practice. The fees for the RAL are in addition to tax preparation fees. Unsurprisingly it is low income filers that tend to receive these loans.

The Office of the Comptroller of the Currency last year denied Pacific Capital Bancorp the ability to underwrite RAL’s and Jackson Hewitt turned to Republic Bank and Trust to fill the void. JPMorgan Chase (NYSE:JPM) announced it would stop underwriting RAL’s in April of this year. It would appear that for the current tax season H&R Block is at a disadvantage, but that in the future these loans will disappear or be severely limited.

For the current year, Oppenheimer analyst Scott Schneeburger estimated the impact to H&R Block’s earnings at $.13 per share.

While the use of an RAL is important to H&R Block, it is far more important to Jackson-Hewitt and Liberty. The report by the 2010 National Consumer Loan Center referenced above notes the following:

Jackson Hewitt continues to derive a startling percentage of its profits fromfinancial products. In 2008, it earned $71 million in financial product fees, or 26% of itsrevenues.It earned $60 million in 2009 in such fees, or 24% of revenues.Thus,Jackson Hewitt is much more dependent than Block on RALs and other tax financialproducts. In fact, one commentator noted:in fiscal 2009 Jackson Hewitt (NYSE: JTX) derived $59.9 million of revenuefrom “financial product fees.” According to analysts and companyrepresentatives, greater than 85% of this line item was RAL and RAC fees thathave minimal associated costs (according to management it is roughly 80%margin). At 80% margin this represents 104% of pretax earnings of $45.9 million.Simply put, Jackson Hewitt loses money without RAL and RAC fees.

The commentator quoted above was actually a contributor to Seeking Alpha. You can read Shareholder Watchdog’s article in its entirety here. (It is well worth your time.)

Regarding Liberty Tax Service, the same report noted the following:

Liberty earned $22.5 million in RAL and RAC fees in 2008, or about 25% ofrevenues.It similarly earned $23.8 million in RAL and RAC fees in 2009, or 29% ofits revenue.About 37% of Liberty Tax customers obtain a RAL; another 37% obtain aRAC.Thus, about three-quarters of Liberty’s customers get some sort of financialproduct. Liberty’s percentage of revenues from RALs and RACs, as well as the highpercentage of its customers who get these products, indicate the chain has a similarRAL/RAC business as Jackson Hewitt.

The federal government has unambiguously signaled that it wants to end the practice of RAL’s. This will hurt H&R Block, but it will be devastating to its chief competitors. As of right now, both Jackson Hewitt and Liberty Tax offer these loans, but one has to wonder how long this will last.

H&R Block has shifted focus from RAL’s to the Emerald Advance Program. This can be used both as a prepaid debit card or a line of credit and is offered by the company’s in house bank. Most competitors lack the scale to offer a similar program.

Mortgage Put Backs

The final reason could prove to be the most significant. This relates to mortgage put back activity. H&R Block sold its mortgage servicing business to Wilbur Ross in 2008 and has been running off its portfolio of loans. The following summarizes H&R Block’s mortgages carried on its balance sheet over the last several years.

Jeff Brown, the CFO of H&R Block, went through the risks associated with mortgage put backs on the most recent earnings call. (The presentation can be viewed here, the transcript can be viewed here). The forthright and transparent manner in which the current risks are discussed is very refreshing and I would encourage you to read through this material, but I will also do my best to summarize the situation.

H&R Block purchased mortgage loan originator Sand Canyon in 1997 and ceased originating mortgages at the end of 2007. These mortgages were mainly sold as whole loans or securitized. If certain conditions are met, the originator may be required to repurchase the loan. This is called a put back. In the case of Sand Canyon, for much of the portfolio, known deception at the time of the sale must be proven for a put back to occur.

The loans that are likely to initiate put back claims are those originated in the years 2005 through 2007 for two reasons. One is the fact that the longer a loan is considered performing, the harder it is to prove fraud. The second is that loans originated in 2005-2007 are the most likely to default and thus produce a claim.

For the years 2005-2007 Sand Canyon originated $83.7 billion in loans. Some of these loans have been paid in full while others are no longer warranted by the company. The initial principal balance for loans that do not fall into either of these categories is $43.7 billion and the unpaid portion of that is $33 billion. Only $500 million of the $43.7 billon total were sold to any GSE (this was Fannie Mae). This is significant because GSEs are the most aggressive and successful in filing mortgage put back claims.

To date claims have totaled $707 million and $58 million has been paid out. The presentation provided for the second quarter earnings call clearly shows that claims can be volatile but show no signs of accelerating. In fact, as time passes the probability of a claim being filed declines since it has been roughly three years since any mortgages have been originated. Of filed claims, 84% have been rejected and for those accepted the loss severity has been 60%.

Sand Canyon is wholly owned but run independently from H&R Block. The unit has $300 million of equity. H&R Block did not itself guarantee many of the originations. In fact, H&R Block is responsible for loans originated with a principal amount of only $1.7 billion. No claims have been received on these loans for about two years now. So while, a worst case scenario of Sand Canyon’s equity being wiped out is not pleasant, any suggestion that H&R Block itself could be at risk for bankruptcy seems extremely far fetched.

Valuation

Based on the factors discussed above, it seems that H&R Block is selling for a rather wide discount to fair value. While this tax season will be poor relative to the prior year, there is no reason to think that H&R Block will not grow its earnings over the coming decade. For one, H&R Block should be able to become a larger presence in the retail tax preparation market – perhaps much larger.

Even though it will continue to place second to Intuit in the digital market, should the 2SS Holdings acquisition close it should allow for reasonable synergies to be exploited. Opportunities exist to improve operational productivity and even mediocre economic growth would induce growth in aggregate tax filings and allow for RSM McGladrey to return to levels of profitability in the range of $100 million pre-tax from about $60 million last fiscal year.

It does not seem egregious to me to forecast free cash flow growth of 3% over the coming decade and no growth thereafter. I used current year earnings estimates (after the RAL announcement) of $1.48 per share as a reasonable proxy for free cash flow per share, estimated a bounce back to $1.75 per share next year and 3% growth thereafter for nine more years, and terminal growth of 0%. Net debt is currently about $174 million. At a discount rate of 10% (I feel this is currently conservative in light of interest rates), these assumptions value H&R Block at about $22 per share. At the current price of $11.77, the yield is in excess of 5%.

It is important to note that the validity of the valuation hinges on two key assumptions: the current year loss of RAL funding will not be a long term hindrance to H&R Block and that the company will not need to increase future reserves for subprime losses. Still, the valuation is about 15 times current year earnings estimates, which seem somewhat depressed. Not an unfair price to pay for an industry leader.